Over the past several weeks, I’ve had a plethora of people in my office with statements in their hands from other advisors. The conversation has become very familiar, and it goes something like this- “I just don’t understand what is going on… I’ve worked with xxx for the last zzz years and we’ve never gone down this bad. Why is it so different this time and how do I stop the bleeding? Am I going to run out of money? When is it going to stop?”
The simple answer to the first question is that there has never been a time in the 234-year history where both the stock and bond market were down more than 15% at the same time! And to make matters worse, most advisors currently in practice have only witnessed a generally falling interest rate environment and tame inflation during their careers.
I’m going to cover a lot here so please bear with me… In 1952, Harry Markowitz published a theory he called “Portfolio Selection” where he opined investors would achieve their “best results” by selecting an optimal mix of high risk- high return securities (i.e. stocks) with low risk -low return securities (i.e. bonds) and Modern Portfolio Theory (MPT) was born. It didn’t take long for the academic world to quantify the historical risks and returns of different asset classes and come up with what should be an “Optimal Mix” for different investors’ portfolios based on how much risk they are willing to take and how long they are planning to invest.
Wall Street embraced the concept whole heartedly as it simplified the game for advisors, allowing them to gather assets rather than manage money, and it took the heat off firms in the courtroom. When performance suffered, a firm could simply say the client completed a risk profile and their accounts were allocated in accordance with historical parameters via the “Pie Chart” and in time, the whole thing will work itself out.
“Pie Chart Investing” has become the go-to solution for investors and for the past several decades it has more or less served its purpose of smoothing out the ride when things got tough. This year, however, the perfect storm occurred when hyper-inflation crept into the markets as a result of the incredibly loose monetary policies of Central Banks around the world in response to the COVID pandemic. When more money supply is put into an economy, we get inflation. It’s that simple! The more inflation we get, the more investors and lenders demand to earn via the interest rates on fixed interest investments (loans such as bonds, cd’s, mortgages, etc.) to maintain the purchasing power of their money in the future. When interest rates go up on new loans, the “market value” of existing loans with lower interest rates goes down!
Let’s look at an example:
One year ago, 10-year Treasury bonds were trading with a yield of about 1%. For every $100,000 you own of bonds purchased then, you will earn $1,000 per year in interest for the next 10 years and then you will get your initial investment back. Today, 10-year treasury bonds are trading with a yield of about 3%. So, for every $100,000 invested, you will receive $3,000 interest each year. Which bond would you rather own?
Obviously, you would want the one that pays more so with all things being equal, the current value of the older bond has to be worth less… How much less? About $2000 per year x 9 years = $18,000. That’s an 18% decline in the market value of last year’s bond! (Note that the longer the bond has until maturity, the larger the multiplier (i.e. # of years) and the more volatile the price move will be) Below is a 1-year chart of the iShares 7-10 Year Treasury Bond ETF to demonstrate the above price move:
Getting back on topic, lets answer “What is going on?”. Both stocks and bonds have moved lower so unlike in the past, investors who did not make tactical adjustments to their portfolio and simply relied on their “Pie Chart” to smooth out the ride received the brunt of “Perceived Diversification” failure. Had they understood the forces of inflation, they could have reduced their interest rate risk by shifting to shorter term bonds, interest rate hedged securities, or cash ahead of the storm but they didn’t so now the question is, “Am I going to run out of money?” That’s an impossible question to answer as it involves looking at how much income is required and for how long, what will the markets do in the future, etc. I believe the real question is, “Can it get worse?” Yes, it can, but it doesn’t necessarily have to…
The Fed has already told us they are going to continue to raise interest rates and begin withdrawing money supply via selling bonds to combat inflation. Quantitative Tightening (QT as it’s called) also has the effect of slowing down the economy. So, the Fed is tasked with getting it just right. They need to cool down inflation while at the same time avoid crushing the economy and there is no handbook that tells them what to do! Sadly, this (and every attempt in the past) is an experiment in real time crafted by some uber smart folks that we trust will get it right. What you need to understand is that the market has already priced in what is expected to happen so knowing they will raise rates doesn’t mean further declines, but expectations can and will change as we progress.
It’s important to know that the stock market is a leading economic indicator. This means the market will typically peak before the economy peaks, and trough before the worst is over. To some extent, stock market participants gather clues from the bond market (and commodities and currency markets) to formulate opinions so those become leading indicators as well. It always puzzles me as to why so many people listen to Economists flapping their jaws on the financial networks to get an idea of where the markets are going… Seems a little counter intuitive, doesn’t it?
Lastly, I’d like to address the remaining questions- When is it going to stop and how do I stop the bleeding? Nobody, and I mean nobody knows for sure where the market is going to go. The markets are made up of a collection of human emotions and the values presented represent how those humans (and computers) are feeling at the moment. The best way to stop the bleeding is to avoid “getting cut” in the first place. To do this, we employ a rigorous risk management process which involves looking at numerous factors every day.
We start with looking at the Macro environment which tells us if conditions are favorable for higher or lower prices, we look at sentiment to tell us if investors are “feeling good”, we use breadth measures to gauge whether or not there is broad participation in the rallies or declines and to assess likelihood of further advancement, we look at the current price trends and compare them to trends in other markets to see if logic prevails or if something is off and we gauge the momentum of those trends to find what we believe offers the most attractive place for our capital at any given time.
Managing Risk takes far more effort than simply filling in the slices of a Pie Chart. This year, Cash has been King when compared to the broader markets. Our research led us to believe this might be the case early on and our process drove a bulk our managed portfolio allocations to focus on defensive positions such as consumer staples, utilities, hedged equities, low volatility equities, ultra-short-term bonds, interest rate hedged bonds, treasury inflation protected securities and yes, Cash! In retrospect, I wish we had more cash (and energy as we only had a bit) but we managed to cut the declines by more than half of that of the major indices and accounts I am seeing that believed in the pie chart.
I am beginning to see some things I like on the price charts and have begun nibbling in with our more aggressive clients the past few weeks. A number of the charts I follow are “challenging” their recent downtrend lines and look ripe for higher prices. Should this type of price action prove itself via the breadth metrics, sentiment, and intermarket trends I would anticipate putting more and more cash back to work in the near future. Either way, I believe the worst of the declines are likely behind us in both the stock and bond markets and feel corporate earnings and seasonal patterns might be coming together to provide the tailwind we’ve all been waiting for!
Should you wish to discuss the current markets, our strategy, and the tools we use to manage risk or just touch base to see how things are going, please don’t hesitate to reach out to our office @ 843-651-2030. Also, feel free to share these newsletters with your friends and family via email and visit us on our website at www.sabowealth.com or www.facebook.com/sabowealth.
Important Disclosures: Past performance is not a guarantee of future results. The statements contained herein are solely based upon the opinions of Edward J. Sabo and the data available at the time of publication of this report, and there is no assurance that any predicted or implied results will actually occur. Information was obtained from third-party sources, which are believed to be reliable, but are not guaranteed as to their accuracy or completeness.